ECB Preview

May 4, 2011

The Bank of England and ECB policy announcements are once again scheduled for the same Thursday, the BOE at 11:00 GMT and the ECB some 45 minutes later.  President Trichet’s press conference starting at 12:30 GMT is a highly anticipated event because opinion is split over whether the next rate hike by the bank is implemented in June or July.  If June, “strong vigilance” language will be inserted into the statement’s text and reinforced during the Q&A portion of the press conference.  If July, the language will promise to “continue to monitor very closely all developments with respect to upside risks to price stability.”

The ECB’s Governing Council implemented an initial refinancing rate hike to 1.25% from 1.0% last month.  The previous rate tightening cycle from a higher base of 2.0% was launched in December 2005 and followed by a three-month lag until a second move.  Back then, the December 2005 statement promised “to monitor closely all developments…”   That level one pledge was escalated in January 2006 to a level two intent “to monitor very closely….” and in February 2006 to a maximum level three assertion that “strong vigilance is warranted.”  By skipping level one language, some would argue that ECB officials purposely gave themselves flexibility to return to “strong vigilance” language in May and an actual rate hike next month.  This seems to be splitting hairs.  During the last tightening cycle, there were times when the ECB jumped directly from level one jargon to level three, so they didn’t need the word “very” in the April statement to go on vigilance alert this month.  Following the ECB these days is a lot like monitoring Kremlin activities during the Cold War.

The case for tightening in June

  • The refinancing rate had been at an historically low 1.0% for 23 months from May 2009 until April 2010.
  • Normalizing at a pace of 25 basis points per quarter would leave policy overly stimulative for too long.
  • Officials waited until price risks had shifted to the upside before starting to raise rates.  A need to catch up ground is easier done with more frequent changes than by escalating the size of the increases at this still very uncertain stage.
  • Euroland’s economy failed to slow last summer as ECB officials had assumed.  Growth accelerated again in the first quarter of 2011.
  • Demand remains robust.  Industrial orders were 4.0% stronger in the first two months of 2011 than their average level in 4Q10.
  • The faster economic momentum in 1Q11 spilled into April.  That month’s composite PMI reading of 57.8 compares to a first-quarter mean of 57.6.
  • Economic sentiment had slid a little by April but at 106.2 that month was only a point below its 1Q average level and well above the long-term average.
  • Euroland’s economy is expanding faster than its rate of potential GDP growth, which is fine when inflation is below target of below but near 2.0%.
  • But CPI inflation is instead above 2.0% and moving further above that level, printing at 2.8% in the year to April and showing an underlying annualized advance of more than 4.0% during the first quarter.
  • Producer prices were 6.7% greater than a year earlier in March.  Even if one disregards energy, the increase was unacceptably high at 4.5%.
  • More than anything, ECB officials are determined to prevent second-order wage and pricing pressure.  This is done by convincing people that they “will do whatever it takes,” and that’s a path that isn’t paved by erring on the side of rate hikes later rather than sooner. 
  • Money and credit growth are again positive.  The level of M3 is considerable above its 4.5% trendline from an end-1998 base.  4.5% is the long-term rate of growth that ECB officials believe to be optimal for ensuring long-run price stability.
  • The ECB is in a period of leadership transition.  At such times, its important to reassure markets that a change in the bank’s president will not affect execution of its mission.

The case for delaying a second rate hike until July

  • Monetary conditions have tightened anyway since the April rate hike because the trade-weighted euro is 1.7% stronger now than then.  The common currency on such a basis has appreciated 5.5% since end-2010 and by 8.6% since May 29, 2010.
  • Euroland’s sovereign debt crisis has intensified over the past month.  Between April 12 and May 3, ten-year bond premiums versus German widened by 270 basis points in Greece’s case, 150 basis points for Ireland, and 144 bps for Portugal.  Unconventional measures are addressing liquidity issues, to be sure, but this may not be the time to rock the boat by loading up another rate hike.
  • Euroland’s two-speed recovery is becoming more pronounced.  Greece is in recession, and Spain is at risk of double-dipping. 
  • Household spending remains suspect.  Retail sales last quarter expanded only 0.3% annualized, as March saw a drop of 1.0%.  The unemployment rate is at 9.9%, 1.1 percentage points higher than in the United States even though joblessness crested at 10.1% in both regions.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.



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